Blossoms and Blight

March 24th, 2013

The Blossoms

There have been a number of encouraging reports these past several months, helping to fuel new highs in the popular SP500 stock index.  After falling off dramatically five years ago, real (inflation adjusted) retail sales finally surpassed 2007 levels.

Housing prices around the country are on the mend.  Although the purchase only home price index is still below the vaulted levels of the bubble years, it is exactly where it would have been if there had been no bubble and housing prices had grown at their customary 3 – 4% per year.

In recent months, the manufacturing sector of the economy has surged upward, rebounding from weakness in the latter part of 2012.  For the past year, the Eurozone has been in or near recession, yet some are hopeful that increased demand in this country and some emerging markets are helping to balance the contractionary influence of decreased demand in the Eurozone.  Let’s hope that this surge in the first part of the year does not fade as it did in 2012.

New claims for unemployment continue to decline. 

The Blight

But a 7.7% unemployment rate and a record 14 million disabled (SSA Source) show that the labor market is still sick.  The percent of working age people who are working, or the participation rate, continues to drift downward.

While the steadily improving retail sales indicate growing consumer confidence, per capita purchases are about where they were in the late 1990s, 15 years ago.

While consumers have been shedding debt, state and local governments continue to hold large levels of debt which does not include promised pension and health care benefits to retirees.

Federal Spending continues to outpace receipts, adding to the debt at a rate of more than 4% per year. At that rate the debt will double in about 18 years, reaching $30 trillion in 2030.  As a percent of the entire economy of the country, the deficit or annual shortfall between spending and revenues is still about 7%.

As housing prices recover and households either pay down or shed debt in foreclosure or bankruptcy, household balance sheets are looking better. What has happened in the past five years is a massive shift of household debt to the balance sheets of local, state and federal governments.

The blossoms catch our eye, inspiring hope, causing some to not notice the blight.  But the stock market, the barometer of millions of watching eyes, tells a more complete story.  While the stock market has shown renewed optimism in the past several months, its inflation adjusted value indicates a more tempered enthusiasm for the long term future of the economy and corporate profits.

Widgets and Labor

March 9th, 2012

Labor costs are the major share of the expense of producing goods and services.  While the percentages vary by industry, a rule of thumb is that labor is about 70% of the final cost of a product.  The cost of labor to produce one widget should keep rising with inflation.  With the passage of time, widgets sell for more and employees demand more pay to produce those widgets.  Not surprisingly, the Bureau of Labor Statistics keeps track of the labor cost to produce widgets; they call it Unit Labor Cost.  In laymen’s terms we can think of it as the Widget Labor Cost.  The cost is indexed to a particular year year; in this case it is 2005.  If the labor cost of a widget was $2.43 in 2005, we’ll set that to 100.  Indexing makes what might seem like arbitrary numbers more uniform.  If the labor cost of a widget in 2012 is $2.67, then the index would read 110, or 10% more than 2005.

Widget labor costs typically fall or flatten out in a recession.  A graph of the past ten years shows that we still have not reached 2007 levels.

Keynesian economists say that labor costs are “sticky”, i.e. they do not decline in proportion to the downturn in the economy and the reduced demand during a recession.  Wages are the price of labor. Union contracts and employment laws do not allow these prices to fall to what is called the market clearing level.  Labor prices thus become too expensive and employers want less labor, resulting in higher unemployment.

Several decades of data allows us to see some changing growth trends in the labor costs to make widgets.

As I noted earlier, labor costs rise with inflation.  The graph below shows the relationship between the two.

After WW2, the rise in labor costs was just slightly ahead of the rise in inflation, allowing workers a greater standard of living and to put away some money for the future.  During the “stagflation” of the 1970s, this gap widened as workers demanded more pay in response to rising inflation while economic growth stagnated.  When the economy recovered in the mid-1980s, we began to see a narrowing between unit labor costs and the rate of inflation.  Had this narrowing stopped around the year 2000 and labor costs continued rising with inflation we would have a healthier work force and a healthier  economy.  But the gap narrowed further until labor costs were no longer keeping up with inflation.  Dwindling increases in labor costs have resulted in more profits for companies.  Although the labor market has a strong influence on the stock market, it is an indirect influence.  Stock prices are directly influenced by rising corporate profits and the perception that future profits will increase at a faster or slower rate.

Because wages do not rise and fall in proportion to the swings in the business cycle, companies took the only course of action left.  They reduced the labor component cost of their goods and services where they could.  Union contracts offer a company less flexibility in responding to downturns in the economy.  Companies reduced their exposure to union labor by outsourcing production to other countries, or by subbing out production to smaller companies with non-union workforces.  

Many people have been waiting several years for employment to recover.  As the chart above shows, there has been a systemic decrease in labor needed to produce each widget.  There is little indication that this trend will end as the economy continues to recover.  Since this economy is consumer driven, it is dependent on a healthy labor market.  A stumbling labor force will not produce robust gains in the economy. 

That is the background, the context for a look at February’s monthly labor report from the BLS, a better than expected report.  The headline job gain was 236,000, far above the 170,000 anticipated employment gain.  The unemployment rate dropped to 7.7% and the year over year decrease in the unemployment rate indicates little chance of recession.

There were other positive signs in this latest report.  Average hourly earnings of private-sector production and nonsupervisory employees broke above $20, increasing to $20.04.  After rising and stuttering last year, earnings have increased steadily since August 2012.  Despite these gains, hourly earnings of production employees are little changed from 1965 levels.

A slowly improving economy gave some hope that we might see the number of discouraged unemployed workers decline below 800,000 this month.  Instead the number rose from 804,000 to 885,000.

The Labor Force participation rate dropped another .1%.  Fewer and fewer workers are being asked to shoulder the benefits of the retired and unemployed.  The core work force aged 25-54 is still showing no substantial improvement.

While employment gains in the 25 – 54 age group have stagnated, the larger group aged 25+ continues to show improvement.  The unemployment rate for this larger group declined another .2% and now stands at a respectable 6.3%.  The employment picture for new entrants into the labor force, those aged 16 – 19, remains bleak.  This past month, the rate of the unemployed in this group increased and now stands at 25%.  Hispanics have seen a 10% decrease in unemployment during the past year but there are still almost 10% unemployed.  The minority group that has suffered the most through this recession has been African-Americans, whose unemployment rate has stayed subbornly high.  There have some small declines in unemployment over the past year, but almost 14% of this group is unemployed.

However, a group that has had persistently high unemployment, those without a high school diploma, saw a significant decline from 12% to 11.2%.

A significant contributor to that decrease is the steady rise in construction employment.

Perhaps not so widely followed is the “Craigslist indicator of construction activity.”  No, you won’t find this one charted anywhere but it does give a clue to what it going on in your area.  Search for “work van”, “work truck”, “step van” or “cube van” in your local Craigslist.  If there are a lot of listings, it means things are not good.  A few years ago, the Denver area used to have pages of work vehicles for sale by both owners and dealers.  This month there are few listings.

Other positives were the increase in the weekly hours worked to 34.5, in the pre-recession range.  Health care enjoyed strong gains as usual.  Professional and business services enjoyed strong gains, offsetting the unusually flat gains of January.  A rise in retail hiring was a nice surprise.

A bit of a head scratcher was the revision of January’s job gains, erasing 25% of the 160,000 job gains that month.  Revisions of that size leads to doubts about the winter seasonal adjustments that the BLS makes to the raw data. 

There are still 3 million fewer people working than in January 2008, when the BLS reported employment of 138 million.

In the past week the Dow Jones Industrial average crossed above the high mark of 2007.  On an inflation adjusted basis, the Dow is still well below the level it attained in 2000 and has still not passed 2007 price levels.  Some argue that the average 2.2% in stock dividends paid out each year partially compensates for the 3% loss in purchasing power.  Others argue that the dividend is compensation for the risks the investor assumes in the stock market and should not be taken into account.  If we disregard dividends, the inflation adjusted SP500 index is – well, it’s better than it was in 1990.

If a buy and hold investor has been in the market since 1990, she has gained 4% per year after inflation.  Adding in a dividend yield of about 2.5% over that time results in a total gain of 6.5%.  Had she bought a 30 year Treasury note in 1990, she would have been making about 8% per year for the past 23 years.  There are three lessons to be learned from this:  Diversify, diversify, diversify.

Capital Goods and New Claims

March 3rd, 2013

This past week came a number of positive economic reports.  The first one I will look at is the Durable Goods Orders, which indicate a willingness by consumers and businesses to commit money now to buy stuff that will last for several years.  A critical component of this index is capital goods, durable goods like machinery which produce more goods and services.  As a key indicator of business confidence in the future, it is one of the trends I watch. (See Predictions and Indicators)

Until the past few months, this component has been particularly weak, warning of recession.  Resolution of the “fiscal cliff” issue at the beginning of the year has sparked more optimism and it shows in the new orders for capital goods.  This deep a decline in the year over year percentage change has been followed with an uptick in the past, only to fall into recession.

When we smooth out the monthly data with quarterly averages, the trend is still in negative territory.

Every week the Bureau of Labor Statistics issues a report on the number of New Unemployment Claims.  This past week, the BLS reported a lower than expected number of 341,000, a drop of 22,000 from the week before. Numbers of more than 400,000 are a major concern.  The weekly series can be volatile; most analysts look at the 4 week moving average to get a better gauge of the trend. 

As with many data series, I am interested in the year over year (y-o-y) percentage change in the data.  Because the SP500 index is a volatile series, I’ve smoothed out the data to a 6 month average to show the negative correlation between stock prices and  new unemployment claims. 

In other words, when unemployment claims go up, the stock market goes down.  This particular data series is good when it is low, bad when it is high so I reverse the percentage change to show its correlation with the SP500. 

On a quarterly basis, this negative correlation has proved to be a reliable trading signal for the longer term investor.  When the y-o-y percentage change in new unemployment claims crosses above the SP500 change, sell.  When the claims change crosses below the SP500 change, it’s safe to buy.

Again, this strategy is for the long term investor who is more concerned with major structural changes in the economy that can cause a significant dent in her savings.  Using this strategy she will not maximize her gains but she will avoid major losses and it does not require that she check her stock portfolio more than four times a year.  An investor using this strategy for the past twenty something years would have bought in the first week of Oct. 1990 and been in the market during the 1990s as the index climbed, then stalled in the mid 1990s, then climbed again.  She would have sold in the first week of Jan. 2001, missing most of the market drop for the next several years.  She would have re-entered the market in the first week of October 2003 and sold again in the first week of April 2008, just before the financial meltdown in September of that year.  She would have bought again in the first week of January 2010 and would still be in the market.

For the long term investor who does not want to devote a part of their lives to reading financial news or watching CNBC, it is often difficult to separate the “noise” – the weekly headlines and economic reports – from the real motion or trend.  This indicator is a low maintenance signal for that investor.

P.S.  You can get this report yourself without much trouble. 
Enter “Fred New Claims” into your browser’s search bar. 
The first link should be “Unemployment Insurance Weekly Claims Report – FRED” at the Federal Reserve.

Click the link, then select the first series “4-Week Moving Average of Initial Claims”. 
When the graph displays, click Edit Graph in the lower left below the graph.
Select the 10 Years range radio button. 
In the Frequency field below the graph, select “Quarterly” and leave the Aggregation method at the default setting of “Average”. 
In the Units field below that, select “Percent Change From Year Ago”. 

(Adding the SP500 stock market index)
Below the “Redraw Graph” button, select the blue bar Add Data Series
Leave the New Line button selected.
In the Search field, type SP500 and select the default SP500 index.  The graph will redraw automatically but it will make little sense at this point until we edit the settings for the SP500 index. 
Select the 10 Year range button for the SP500.  Make sure you are editing the SP500 data graph and not the New Claims indicator. 
Change the Frequency field to “Quarterly” just as you did for the New Claims. 
Change the Units field to  “Percent Change From Year Ago” just as you did with New Claims. 
Click the Redraw Graph button and voila!